Under The Southern Cross

It’s time to take a leaf out of Warren Buffett’s book and getting greedy now the rest of the market is fearful. By Charlie Aitken

Warren Buffett has some interesting advice for investors in Berkshire Hathaway’s 2004 annual report. He writes: "Try to be fearful when others are greedy, and greedy only when others are fearful." Let's focus on the second half of that statement, "Greedy only when others are fearful."

In an Australian equity market context that is right now. The average investor and commentator simply doesn't believe what he is seeing. There is broad scepticism about the sustainability of Australia economic and equity market strength, and that is clearly telling me to be "greedy" and hold on to my equity market positions. In many cases I actually want to increase them.

The higher the equity market goes, the more sceptics air their views, and it's the complete opposite of what every mass psychology textbook would tell you.

“SMART INVESTOR”

On this point, I loved in the AFR Smart Investor segment that 15 broker recommendations were printed on Telstra, and not a single one was positive. That's the greatest signal of all. You now know the stock is a medium-term buy. It's as simple as that. If I could get access to $30 billion in private equity funding I would bid the Federal Government for 51% of Telstra at $4.50, and set the Three Amigos on a rampant cost-cutting and revenue driving spree. My $30 billion would be self-funded in fully franked dividend streams, and in five years’ time I'll sell all my stock back to the same 15 brokers at $7 a share.

The Prime Minister is correct: the biggest impediment to Telstra's performance is the Government's shareholding itself.

Enough dreaming, let’s find something we can get involved in that's unloved, somewhere near a cyclical earnings bottom, yet with real leverage to any recovery.

EVERYONE CALLED THE DEATH OF THE PROPERTY MARKET TWO YEARS TOO EARLY

I think everyone has forgotten just how overblown the residential property sector became. The vast bulk of commentators called the death of the residential property cycle two years too early, and I can't help but wonder whether we are seeing exactly the same thing happening with regard to the domestic equity market.

Domestic rental yields were driven to ridiculously low levels (below 2%), while residential property prices peaked at levels 20% above what anyone thought possible. We have extended asset class cycles in Australia, and in 2005-06 equities still stack up as the asset class of choice. Earnings growth of 10–15%, with 4% yields, and at pretty much a worst case we will see low double-digit total returns from domestic equities. That's going to kill any other domestic asset class.

WHAT YIELD WILL THEY DRIVE THIS MARKET DOWN TO?

The big question is what will the all-powerful superannuants of Australia drive the yield of the equity market down to? They look at this market in a "fixed interest" style, and this market will only peak when superannuants have driven the grossed-up yield to a level they no longer find attractive verus unfranked cash. Yet as long as corporate Australia can keep growing dividends, the superannuants of Australia will have real trouble driving the tax-effective yield of the market down without taking the price of equities significantly higher. As long as we see dividend growth, this equity market will be underpinned.

What the pessimists all miss is that the equity market is a discounter of the future. The future is clearly getting brighter for the Australian economy, and Australian corporate earnings, particularly in terms of previous consensus forecasts for growth. Business spending on investment and capital expenditure is the largest surprise on the upside, and that is corporate Australia reinvesting in growth. De-bottlenecking of transport infrastructure will be another driver of growth.

UPGRADES WILL COME

I still think the market is underestimating Australian GDP growth for 2005-06, and in turn, Australian equity earnings growth. In many sectors, particularly exporters, equity linked earners and engineering/steel, earnings are underestimated by about 20%. If they are underestimating earnings growth, they are also underestimating the all-important dividend growth. We think the AGM season will be upbeat, and that will lead to consensus earnings estimates being revised higher in those stocks leveraged to the new drivers of GDP growth, those being exports and business investment.

I remain strongly of the view that it is actually contrarian to be positive, and as long as that remains the case, we will remain positive on high quality Australian companies of all market caps. We may well be "fools", but "fools" are making all the money. So let’s go looking for some ideas.

OPPORTUNITY KNOCKS

Great stock specific opportunities present themselves when the market starts being priced daily on global macro-economic developments, and you find Australian stocks get tarred with the same brush effecting globally listed stocks. The trading community takes a genuine "guilty by association" attitude to global developments, and Australian companies can't fight the scepticism as they are in a self-imposed blackout window ahead of the AGM season.

Over the next two months you must think local. Keep solely focused on local influences, and take advantage of the global influences that will be affecting daily pricing and trading sentiment. When the market goes broadly "macro", the real medium-term opportunities are "micro".

Whenever there is globally driven volatility in Australian equities, remember three things: the state of the Australian economy; the state of corporate Australian balance sheets; and the demand/supply imbalance in the asset class driven by full employment, rising wages, and compulsory superannuation. Always keep those three points in the forefront of your mind, and buy the trading dip in our highest quality "growth plus yield" exposures.

It's easier said than done, as the days to "buy the dip" always look dreadful. It's the days when the Dow is down by 100 points, the short sellers are having a go, and the global brokers think it's the end of the world. They are the days you simply have to close your eyes and buy quality.

DON’T BE A VICTIM

Instead of being a victim, lets be the predator. Let’s buy the targets, not the issuers.

One of my key strategic ideas is to buy "irreplaceable industrial assets" at or near the low point of their earnings cycle. Our two large cap recommendations on this theme are Harvey Norman (HVN) and John Fairfax Holdings (FXJ).

Many investors say "you're too early" on these two consumer discretionary stocks, yet I think that misses the point of why I am recommending them. In both stocks we can't be certain that we have seen that absolute bottom in their earnings, but I can tell you if we haven't seen the bottom, we've seen something very damn close.

These aren't "quant" or "earnings momentum" based ideas, they are irreplaceable strategic asset play ideas. Ask yourself how many companies in tremendous earnings shape have been taken over at the high point of earnings and price/earnings ratings? Very few. Then ask yourself how many have been taken over within sight of the low point of earnings and p/e rating? Clearly the opportunity to add value is from a cyclical low in earnings, and of course the analyst community, ever unwilling to take risk, has a 3:1 negative recommendation to positive recommendation ratio on these stocks.

BUY BUSINESS CYCLE LEVERAGE

Business confidence remains strong, and we continue to believe some of the best investments for 2005-06 and 2006-07 are leveraged to the business investment and business spending cycles. That clearly includes the media and advertising sectors, while we are also clearly on the cusp of an IT hardware and software upgrade cycle.

Yet a strong corporate sector also needs printing paper, particularly in this age of widespread e-mail communication. Fine paper stocks have been dreadful performers, but there is a contrarian opportunity presenting itself here.

There was a very good article in Barron's last weekend, which spurred my interest in this beaten up sector. Just remember, it wasn't that long ago that you couldn't read a positive word on the steel, building materials, or refinery sectors, yet now the world loves these "old economy" sectors as years of under-investment in capacity have led to demand outstripping supply.

Think of another "old economy" sector that has been in the doghouse for years that looks very similar to the sectors mentioned above a few years ago? Yes, it's paper.

EASY MONEY = POOR DECISION

When capital is abundant, poor strategic decisions are made. The temptation to acquire and grow is large because investment banks are educating the corporate world about just how much money they can raise, and how much cheaper equity is than debt.

In the past six months, but particularly in the past three months, I have not seen a single capital-raising that was described as "questionable" or "strategically poor" by an analyst. I have, however, seen the words "company-making acquisition" used very regularly.

VERY FEW ACQUISITIONS ARE TRULY COMPANY MAKING

Let’s set the record straight on this. Very, very few acquisitions are truly "company making". In the past decade I would call Wesfarmers’ purchase of Howard Smith as truly "company making", as was St George Bank's purchase of Advance Bank. In recent times the only three deals I would consider close to genuine "company making" transactions are Sims Group’s merger with Hugo Neu, CSL's purchase of ZLB, and Toll/Patrick’s purchase of Pacific National.

Too many people seem to confuse "EPS positive" with "company making". The funny part is most of the truly "company-making" deals involve short-term EPS dilution of some form, and require a "leap of faith" for investors to jump.

When fresh equity is easy to raise, it's pretty easy to "buy EPS growth" and please the short-termists, but that clearly doesn't mean a deal was "company making".

STEEL

We continue to see organic earnings, cash flow, and dividend growth from the domestic steel sector. Remember, 80% of domestically produced steel finds an end use in Australia, and it is "steel intense" business investment that continues to drive domestic GDP growth surprise.

Nippon Steel, Asia's leading steel maker, has raised its full-year profit forecast by 17% to ¥310 billion, reflecting the company's strong pricing power for its high-grade steel. Despite the huge increases in raw material costs, Nippon and rival SFE, have been able to secure successive price increases for the high-grade steel used in cars and consumer electronics. Nippon's average first-half price for its steel products was $US650 a ton, up 24% compared with the same period last year. Also supportive of higher prices, the Tex Report expects HRC prices in the US to move as high as $US600 a ton after steel producers raised prices in the aftermath of Hurricane Katrina. US domestic prices have recently recovered from $US460 in July to $US500 in early September.

Nippon also expects lower quality Chinese exports will result in a "bipolar split" between high-grade and commodity-grade steel products. Nippon's comments confirm my view that BlueScope's (BSL) downstream steel products division will insulate the company from any weakness in HRC pricing due to increased low-grade Chinese steel exports.

The Coated Building Products division has achieved substantial price increases and I expect the company's strong Asian industry positioning should be a strong positive for further margin improvement in this year and next. I think analysts continue to underestimate underlying steel demand and pricing and earnings forecasts of $750 million will prove too conservative. David Whittaker expects BSL to earn $1 billion again this year, which has the stock trading on a seven times multiple and a dividend yield of 6.7%. This is cheap "growth plus yield", with clear and substantial positive earnings revision risk. $13.00 target

Go Australia!